Inflation Alert


[Editor’s note: You are receiving this version of The Daily Reckoning Week in Review as part of your subscription to The Daily Reckoning Australia.]

Imagine if the actual length of a metre shrunk each year.

One day you’re 1.80 metres tall, the next you’re 1.84. You would constantly get speeding tickets, even though your speedometer would tell you you’re under the limit. World racing records would be broken every year. Your GPS would think you’re a complete idiot for missing turn-offs. Artillerymen would overshoot the enemy. And containers wouldn’t fit snugly onto ships.

In short, there would be chaos. And yet, central banks spend their time trying to achieve much the same thing, only with the currency.  By changing its value each year, relative to goods and services, central bankers ruin the financial plans of the people and companies in their economies.

More importantly to you, inflation erodes the value of the measure you use to gauge the performance of your portfolio. And the sustainability of your household budget. It throws everything out of whack and into the arena of uncertainty.

In the future to come, what seems like a profit could turn out to be a loss. A carefully planned budget could go to where dead central bankers are. (The graveyard.)

The thing to remember is this change could begin to happen quickly and unexpectedly. Like say … now.

Inflation alert!

“Fruit and vegetables set to rise more than 70 per cent” according to IBISWorld.

What you don’t know yet (unless you clicked on the link) is whether this refers to global markets or Australian supermarkets. With floods (and now storms) ravaging many food producing areas of Australia, and Federal Reserve Chairman Ben Bernanke releasing even bigger torrents of money, it’s hard to tell what’s what. Of course, it could be that Wal-Mart’s decision to stock healthier food is causing a jump in fruit and veg prices. In that case, you can blame your grocery bill on Ms Obama, who led the Wal-Mart initiative.

Each of these changes in price are completely different in nature, yet they all show up in the same way. And people react to prices. Farmers decide how much to plant based on prices. How many people go into farming depends on prices. How many people are employed in farming depends on prices. How much money is spent on farming equipment depends on prices.  And it’s the same in all industries across an economy. Prices are the signals that allocate resources.

If food prices are increasing by 70% because of flooding, it will compensate the farmer for crops lost, which allows him to plant next year’s crop.  If prices rise because Wal-Mart buys more food, then farmers will know to plant more next year. So, using prices and profits, the market adjusts supply appropriately.

But don’t go charging into the hinterland looking for farms to buy just because prices signal profits are being made. First consider what happens when a central banker prints money and causes prices to increase. A popular misconception is that all prices in the economy will rise simultaneously. But money doesn’t appear everywhere at once. It ripples through the economy, causing increases in prices to happen in specific places before being fully absorbed by the global economy.

If the global reserve currency is being printed, higher prices could show up outside the nation that is home to that currency. Like, say, hypothetically speaking, in wheat prices in Egypt or chilli prices in Indonesia.

New money begins its life with privileged bankers, who deal with the central banks, where it is created. The money will either flow into financial assets or loans. Loans usually finance capital spending, so capital intensive industries find favourable lending standards because there is more money to go around. This encourages them to invest in projects that seem profitable. Usually these projects involve producing the goods that have gone up in price as a result of the new money rippling through the economy. They think the increase in price is a signal of profitability.

But, as the money stops rippling through the economy, prices adjust and many of the investments made by companies turn out to be unprofitable. Sticking with our example, farmers who borrowed money on favourable terms to invest in food production will learn the price of food only went up because of inflation. Now that all other prices have risen as well, farmers won’t profit the way they expected. What’s more, there are now many other competitors who also spotted the high prices and went into farming.

Soon, the farming sector and wider economy fall into a recession. Crucially, the economy experiences a credit crunch, as it is the industries that borrowed heavily that are struck hardest.

This is how a change in the money supply causes a misallocation of capital and subsequent recession. If you look at the US money supply before the Great Depression and the recent recession, you will notice that it first increases, inciting a boom, and is then followed by a bust.

This is why Austrian Economists are so good at predicting recessions. They see any boom triggered by monetary policy as an unsustainable boom based on malinvestments, which will be exposed when prices adjust for the inflation.

As you will have figured out, the increase in food prices mentioned in the link above is due to the flooding in Australia. At least part of the increase, that is. The price will incite investment into food and the issue will solve itself. As it would on a global scale … absent government interference.

But not everyone agrees. Columnist Ambrose Evans-Pritchard thinks it will take strong leadership to solve the global food crisis.

“Can the world head off mass famine? Yes, with leadership. The regions of the former Soviet Union farm 30 million hectares less today than in the Khrushchev era, and yields are half Western levels.

Wait, wasn’t it “strong” leadership that gave you the Soviet Union and its famines. And wasn’t it grains in particular that were in severe shortages due to attempted management of the economy?

It gets better:

“There are untapped hinterlands in Brazil, and in Africa where land titles and access to credit could unleash a great leap forward.”

If those last three words didn’t make you cough up whatever you were drinking while reading the Daily Reckoning (which is probably a good time to be drinking), then you might have missed some remarkable irony. Whether it was intentional or not, Pritchard referenced Chairman Mao’s economic policy, known as The Great Leap Forward. It resulted in – you guessed it – grain shortages.

Yes, that’s what strong leadership gets you. The very thing you are trying to prevent.

And there are currently few stronger leaders than central bankers. Considering themselves to be tasked with generating an economic recovery, they have taken remarkable steps attempting to do so. But with Bernanke creating dollars at unimaginable rates, you do have to wonder where they are going. The dollars that is. We mentioned above where central bankers go.

The remarkable correlation between Bernanke’s QE activities and stock markets is a symptom of the effects new money has on financial markets. To be honest, it has turned the American stock market into a complete farce. But the ASX seems impervious to the US’s lead lately. Perhaps because the AUD/USD exchange rate is absorbing the move instead of passing it on to the ASX.

But not all the money is going into financial assets. As you may know, banks aren’t lending much recently, except to the government. By directing hoards of new money into Treasuries and financial markets, but not the real economy, the banks are still creating bubbles. Not unlike the one in housing.

The misallocation of capital, then, can be found in stock markets, bond markets and especially government debt. This has allowed the massive government deficits of the world to be financed. Not only is government spending inherently wasteful (or the private sector would be taking its place), but the amount of spending that is supported by newly created money is unsustainable.

At some point, the public sectors of the world will have a rude awakening, just like the building sector had in 2007 and 2008. Many will go insolvent. (Rumour has it that the EU, IMF and ECB have reached agreement on Greece’s restructuring.) Some governments will attempt to print their way out of insolvency. Either way, bond markets will be routed.

So you can be sure to see government spending go down. Unless some authoritarian form of government emerges. One where choices are limited to the bad and the really bad. And you only get to choose every couple of years. Oh wait, we already have that.

Justin Jefferson at illustrates the absurdity of our governmental system with an excellent metaphor. In the world of Fast Food Democracy you can only choose one fast food chain every three years. During the three, you have to stick to that one only.

Of course, you could always choose to eat something else, right? Sadly, the Fast Food Democracy forbids it. Anyone caught growing vegetables gets fined. If you can’t pay your fine, you go to gaol.

Sound fun? If you don’t like the idea, what does that make you? Anti-democratic of course.

Tut tut, you rebel.

Of course, the fast food chains that never get started, because they aren’t allowed to compete, don’t get a mention. So not only is your choice of fast food limited during the election cycle, you don’t get much of a choice when election time comes up.

Most people realise that a democratic system of fast food wouldn’t be very satisfactory. Yet we apply the same system to our government.

Politicians only let you choose every few years. And you don’t choose policies, you choose people. Once you have chosen them, who knows what they will “serve” up.

The solution to both problems is of course to introduce competition. Let the people choose every day. No, every meal. And, all importantly, let them choose for themselves only. That’s what they do with food, so why not do it with everything else?

Until next week,

Nickolai Hubble.
The Daily Reckoning Week in Review

About the author: having recently escaped from academia, Nick decided to drop his tights (the required attire of a trapeze artist) and joined Port Phillip Publishing. Instead of telling everyone about the Daily Reckoning, he now spends his time writing for the weekend edition.

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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